Has health-care reform eroded pharma's moat? I'm here today with Damien Conover--he is associate director of pharmaceutical research at Morningstar--take a look at this question.

Damien, thanks for joining me today.

Damien Conover: Thanks for having me, Jeremy.

Glaser: So, let's take a step back and look at why pharma firms have moats in the first place. How much competitive advantage do these businesses really have?

Conover: I think that's a really good and an important question. At Morningstar, we rank all the large pharmaceutical firms as wide economic moats, and the main reason behind that is really the patent protection on their drugs. So, as pharmaceutical firms develop new drugs, they get patent protection, and in that time period, while the drug is still under patent protection, they can charge any price they want, and hence get very strong returns on invested capital. That's kind of the key point to why these firms have wide economic moats.

But it's also important to remember that these firms are also very good at research and development, albeit the research and development productivity has declined over the last few years, there is still very strong new product flow coming out of these firms.

Then also, it's important to remember the distribution network. While not as important as the patent protection, it is critical to have a big pharma firm to really launch a new drug because of the power of their salesforce.

Again, over the last few years, this has been a trend that's been declining, not as strong as it once was, but really the key to remember here is the patent protection on why these firms have wide economic moats.

Glaser: It's been a little bit over a year since President Obama signed health-care reform into law. What impacts have they seen so far? Or has the fact that a lot of the major provisions haven't come into force yet [meant that] there hasn't been a lot of change to their businesses?

Conover: We have seen a few changes happen already, and like you mentioned, some of the changes won't happen for a couple of more years down the road, but so far, if you take a look at U.S. health-care reform, it really hurts the pharmaceutical firms in the near term and helps U.S. pharmaceutical firms in the long term, and what I mean by that is, there have been certain provisions that have already been passed that pharmaceutical firms are already on the hook for, starting in 2011.

Primarily, I'm talking about the fee that the pharmaceutical firms are now responsible for. It's kind of their way of helping to pay for U.S. health-care reform, and each firm is allocated a fee depending on their share of the market. Then also pharmaceutical firms are responsible for increasing rebates for folks buying drug coverage in Medicare Part D coverage.

So, those two things have weighed on pharmaceutical firms' earnings this year, and in the first quarter, we are anticipating it to weigh on pharmaceutical firms by about 6% for the pharmaceutical firms that are really focused on drug development [with] drugs in the branded space like Bristol, AstraZeneca, and then we expect the firms like J&J, Abbott--for those firms it's going to be more of a 1% to 2% hit because they are more diversified.

So, that's how we see it impacting these firms from an earnings standpoint. So, a little bit of a drag in 2011. But remember in 2014, with the mandated health insurance, we expect a huge inflow of patients, higher demand for U.S. health-care goods and services and drugs. We expect by 2014 that the dynamic will shift and big pharma firms [will] actually start to see a benefit from U.S. health-care reform, and in total, over the next 10 years, we really see it as a net neutral to the large pharmaceutical firms.

Glaser: So, has the reform then impacted your view of their competitive advantage?

Conover: You know, I'd say, it has to some extent. There is going to be more buying power by government over the next few years, and I think the ability for pharmaceutical firms to price drugs at whatever they want, that's going to be diminished to some extent.

So, I would say that there is a trend that's likely going to be more negative for big pharma. But that being said, I still think the firms' economic moats are still very, very wide and very strong, but going forward, I think there is going to be a little bit of a drag, and I think that firms will be able to offset some of this drag by cost-cutting, but I think the competitive dynamic shift a little bit, but overall, we still think they are wide economic moats.

Glaser: Maybe a little bit of dirt in the moat, but generally their patent protection isn't going away, and they'll still be able to reap rewards from it?

Conover: Absolutely. If you rewind a little bit and take a look at the discussion around U.S. health-care reform a couple of years ago, there were thoughts to potentially go to just a one type of payer, like a European system, where the government takes care of all the drugs, which is something where, then, the buyer has an extreme amount of negotiating power, and hence then we would probably re-evaluate the moats a little bit more carefully and determine that potentially that these moats could be under further threat, but really the way that U.S. health-care reform came about, it's a negative drag, but overall, we still think they have wide economic moats.